Tuesday, January 15, 2013

How do legal tender laws affect purchasing power?

We discussed the definition of legal tender last week. Legal tender, in short, is any medium that can always be relied on to discharge a debt. Here's the next question—how does the conferral of legal tender status on an item affect that item's value? Here are my rough thoughts.

As I did in an older post on chartal coupon money, I'm going to make use of McDonald's Corporation to illustrate monetary phenomena. Let's say McDonald's wants to create its own form of legal tender: frozen meat patties. It does so by setting the 4 inch wide, 1/4 inch thick frozen beef patty as legal tender for all its receivables. This means that anyone indebted to McDonald's has to settle their debt with legal tender patties. If they owe $1000, they have to pay with $1000 worth of beef.

Next, McDonald's requires its suppliers, many of whom are entirely dependent on McDonald's for survival, to abide by its legal tender rules. Rather than give up their relationship with McDonald's, they accept. As a result, not only can debts due to McDonald's be settled in patties—so can debts due to a number of ranchers, bakeries, farmers, wholesalers, etc who are part of the McDonald's supply chain.

These developments will immediately increase the market price of 1/4 inch frozen beef patties. Why? Given the patty's new capacity to discharge all debts due to both McDonald's and its suppliers, it will be regarded as more liquid than if it didn't have this status. Instead of storing just one box of hamburger patties for future consumption or sale, a household or restaurant might keep a second in reserve for potential debt repayments. Since it provides an extra range of liquidity services, a 1/4 inch frozen patty will thereby gain a premium over its pre-legal tender market value.

Let's say that instead of beef patties, McDonald's declares that a new intrinsically worthless issue of yellow McDonald's certificates is to be made legal tender for $100 worth of debt. Anyone can buy the certificates at McDonald's, either with cash or in kind (say by selling supplies) and use them to pay off their debts to McDonald's or its suppliers. As debts are paid off, suppliers who accumulate unneeded certificates can offload them in the secondary market where debtors who need to settle debts can buy them.

Because McDonald's and its suppliers will always accept 1 certificate to settle each $100 worth of debt, arbitrage dictates that certificates will trade near parity. After all, if the market price of certificates falls to $90, all one need do go into debt to either McDonald's or one of its suppliers to the tune of $100, purchase a $90 certificate with the proceeds, use the certificate to repay the $100 debt, and enjoy the remaining risk-free earnings of $10. Of course, if McDonald's and its suppliers limit the market's ability to borrow from them, then this limitation might reduce the effectiveness of arbitrage and cause certificates to trade at a discount.

On the other hand, if the market price of certificates rises to $110, all one need do is buy certificates from McDonald's for $100 and sell them for $110 until the gap has been closed.

In any case, what is interesting here is that legal tender laws can add a liquidity premium to an already valuable commodity, or bestow market value on worthless bits of paper. That's not to say these certificates are pure fiat. After all, what makes them valuable is that they represent a liability of sorts, acceptance of which is backed up by power. Pure fiat objects, on the other hand, are items that circulate despite being no the liability of no one and having no intrinsic usefulness whatsoever.

As long as there are unredeemed certificates, or float, McDonald's earns seigniorage profits. After all, if $1000 worth of certificates are in circulation, the company pays no interest these certificates but can invest the proceeds in interest yielding bonds. The wider the circulation of McDonald's certificates, the larger the float and juicier the profits. Other large companies will of course be interested in enjoying seigniorage, and one can imagine them also trying to exert market power over their supply chains with legal tender rules. Their ability to do so will always be counterbalanced by competition, for if seigniorage gets too onerous, McDonalds' suppliers might flee to competitor Burger King, which may have less onerous seigniorage or no legal tender rules at all.

Extreme abuse of seigniorage would eventually result in certificates being worthless. Say McDonald's gets greedy and starts to sell certificates for $110. Anyone indebted to McDonald's or one of its suppliers is thus forced into the perverse position of having to acquire a certificate for $110 in order to settle a $100 debt, giving the debtor an immediate $10 loss. As a result, no one will choose to ever indebt themselves to either McDonald's or its suppliers. Soon, all debt in the McDonald's supply chain will have expired. Certificates will be worthless since their only source of value was their ability to discharge debts—and there is no more debt to discharge.

So is modern central bank money akin to meat patties or to yellow certificates? If the former, then a $100 bill is already valuable without legal tender laws, earning only a small premium when rules confer on it legal tender status. Removing legal tender status would do little to affect its purchasing power. If the latter, then central bank money would be entirely worthless without legal tender laws.

13 comments:

"In any case, what is interesting here is that legal tender laws can add a liquidity premium to an already valuable commodity, or bestow market value on worthless bits of paper. That's not to say these certificates are pure fiat. After all, what makes them valuable is that they represent a liability of sorts, acceptance of which is backed up by power. Pure fiat objects, on the other hand, are items that circulate despite being no the liability of no one and having no intrinsic usefulness whatsoever."

Fiat means BY DECREE, and decrees are enforced by state "power." Fiat is not independent from power. Power begets fiat money.

Pure fiat does not mean "items that circulate despite being no the liability of no one and having no intrinsic usefulness whatsoever". Pure fiat means "items that circulate because of the liability of going to jail at the hands of powerful people if you don't pay them what they want, in the denomination they want."

Yes, good point. There are a zillion definitions for fiat. I'm using the definition that comes from modern monetary economists like Goldberg, Wallace, and Williamson. In general that's the definition I use on my blog. I suppose I could use the phrase "intrinsically useless money" instead of fiat money.

But you're right that the use of the term fiat money is typically associated with state power. On my blog I call this state-issued coupon money.

Note that if your definition of pure fiat is "items that circulate because of the liability of going to jail at the hands of powerful people if you don't pay them what they want, in the denomination they want"... then that sort of money doesn't exist today. You're free to not accept US dollar bills, and you're free to negotiate your debts in such a way that US bills aren't necessary.

"Note that if your definition of pure fiat is "items that circulate because of the liability of going to jail at the hands of powerful people if you don't pay them what they want, in the denomination they want"... then that sort of money doesn't exist today. You're free to not accept US dollar bills, and you're free to negotiate your debts in such a way that US bills aren't necessary."

You are not free to negotiate your debts in such a way that US bills aren't necessary, because regardless of what commodity you do negotiate your debts in, your income will be taxed by the IRS in "equivalent" dollars.

So if you agree with Mr. Smith to trade gold for labor, then he who earns gold will be assessed an income tax in DOLLARS, not gold, calculated at whatever the devalued dollar rate that prevails. You can't just agree to trade in gold and whatnot, and be free of the dollar.

Since you will be taxed in dollars, what will happen is that you are thereby coerced into engaging in a particular activity that enables you to acquire dollars. Since dollars are owned by people and are private property, typically you will have to do something for the owner before they will give you their dollars. So you end up right back in the dollar regime, trading your goods and services for dollars.

It would be like McDonalds demanding at gunpoint that you pay them 50% of your income in "equivalent McD's beef patties". OK, well that means if you want to avoid being shot at, then either you defend yourself with force, and risk harm/death, or, you capitulate because they're too strong, which means you'll have to go out and offer goods and services to anyone who has the requisite "beef patties" that you need to pay taxes on your non-beef patty income.

I hate to be the person to break this to you, because your post was very well written and thought provoking, but unfortunately we live in a world with more coercion than you seem to realize.

You're right that the tax obligation requires payment in legal tender, at least in theory. Legal tender in the US is Federal Reserve notes and US coin. I say in theory, because an interesting quirk is that in practice the IRS asks that people do not submit payments with notes or coin via the mail. As a result, 99% of taxes are paid with non-legal tender like cheques, direct deposit etc. This would imply that legal tender laws have no teeth since the IRS itself ignores them.

But let's ignore this and assume the government requires tax payments in legal tender. You may remember my McDonald's coupon theory post. McDonald's can force everyone to pay their "McD tax" with McDonald-issued coupons. This is equivalent to a government that requires legal tender coupons in the discharge of taxes.

You don't have to submit to McDonald's tax requirements, insofar as you are willing to eat at Burger King, which does not require legal tender for Whoppers. The same goes for US legal tender. If the US requires you to settle your tax with US coupons (which, as I've pointed out above, is not the case in practice), then stop doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules.

I realize there is a lot of coercion the world, but I don't think that legal tender laws exert as much coercion as is commonly supposed. Is McDonald's acting coercively if it requires that dues to McDonald's can only be discharged with McDonald's coupons?

"Since it provides an extra range of liquidity services, a 1/4 inch frozen patty will thereby gain a premium over its pre-legal tender market value."

What does "market value" mean?

Prior to patty monetization, a restaurant might buy patties for $1 each, but could only sell patties (say back to a patty supplier) for $.90 each. After monetization, all transactions would be for $1 per patty because of the new liguidity (many more willing buyers). So, patties might be worth more in only some transactions, and not worth more overall.

Say everyone wants a reserve of patties for savings. This would increase the demand for patties for a (maybe long) while, until the reserves are established. If this happens over a reasonable length of time, it might only increase the patty price by 1 cent. Or, it might lower the patty price if the larger scale and more predictable demand for patties made production more efficient.

There are many things which one could suppose, but how could one know which suppositions were correct, or which unconsidered side effects are important?

By market value, I mean whatever price is quoted in an organized central spot market for patties, say like the gold market or the stock market.

"So, patties might be worth more in only some transactions, and not worth more overall."

Since I'm thinking in terms of a centralized market for patties that everyone can access, the additional liquidity affects everyone equally. Most markets are organized in a distributed fashion and wholesalers get wholesale prices, retail gets retail prices etc. This certainly muddies the water and may affect the way in which a legal tender premium gets distributed.

"Or, it might lower the patty price if the larger scale and more predictable demand for patties made production more efficient."

I'm just taking the short cut and assuming ceteris paribus, the granting of legal tender status to patties will increase the demand to hold patties for transactional purposes.

Tell me, why is it that in the real world, your McDonalds (ie the govt) has handed over the creation of patties to the banks? Why does a govt issue bonds to raise money? Why doesn't it just create/print money, and loan it to the banks via its central bank? Or am I simply describing social credit?

Tradition, I suppose. Politics too. Also, economists are more or less unanimous in advocating independent central banking, and that has an effect on banking structure.

The idea of social credit, at least as far as I see it, is... why can't everyone print/create money&credit? Associated with this is the idea that if everyone=the state, then just have the state monopolize the issuance of credit.

It just strikes me as the most fundamental question regarding the global financial and banking crises. A government has the power to create money out of thin air; perhaps the most significant of its powers after the ability to wage war (although the latter requires the former). Yet almost every govt on the planet has handed this power to the banks, and as a result we have the shadow banking system, credit bubbles, crippling private debt etc..ie, the primary causes of the GFC. Why is no one advocating this change, or at least, the alternative be investigated as an option...? I understand neo-classical economics provides a convenient curtain to disguise this, but there are plenty of smart thinkers out there who I would have thought might have raised this? The trillion dollar coin was a fascinating - if brief - debate, because it basically proposed this..

This is good. These "yellow notes" are essentially how I see fiat money (though the penalty for defaulting on obligations is important, this is how I argue that "fiat" money is in fact linked to real goods rather than being some kind of "pure liquidity" asset). The patties are a little different. I agree that this may add a small liquidity premium to them but it would likely be very small if the debts could be paid also in dollars (how willing would people be to hold patties instead of dollars if the rate at which the patties could be used to pay off the loans were determined by the dollar price of the patties?).

This is pretty similar to a private credit creation thought experiment I went through here.

http://realfreeradical.com/2013/10/19/banks-and-credit/

Also your problem of debasement of the notes is essentially what I mention in the post I just put up which is solved by a gold standard in a "free banking" system and a reserve requirement in a fiat system.

(In the thought experiment, McDonald's debt could only be paid in patties).

In any case, are modern US dollars like the yellow certificates or the patties? Neither are Samuelsonian monies, and both make sense. What does the evidence point to? What features of the real world (or missing features) point to either of the two?